Capital_Structure_Lecture2 (1).pdf - Capital Structure 2 1...

Limits to the Use of Debt•March 2014 was a tough month for fast food. First, on March 10, mall and airport pizza company Sbarro announced it was filing for bankruptcy. The company stated that foot traffic in malls had dropped in recent years. This fact, coupled with the company’s debt, meant management was forced to turn to bankruptcy. This filing was Sbarro’s second bankruptcy in three years. It had filed for bankruptcy in April 2011, emerging in November 2011. Also in March 2014, sub chain Quiznos announced that it would be toasted without a bankruptcy filing. At one point, the company had more than 5,0002

restaurants, but as rival Subway grew, the number of Quiznos stores dropped to 2,100. Women’s clothing retailers also faced problems in 2014 as both Coldwater Creek and Dots were forced to file bankruptcy.As these situations point out, there is a limit to the financial leverage a company can use, and the risk of too much leverage is bankruptcy. In this lecture, we discuss the costs associated with bankruptcies and how companies attempt to avoid this unhappy outcome.The previous lecture began with the question, “How should a firm choose its debt–equity ratio?” It first presented the Modigliani-Miller (MM) result 3